Our shadow money analysis relies in part on a belief that government debt can substitute for money in order to meet demand for liquidity.

This is a surprisingly old idea.

In his 1790 Report on Public Credit (source courtesy of George Washington University), Alexander Hamilton argued that government debt could circulate almost as money, and this could have many beneficial effects:

It is a well known fact that in countries in which the national debt is properly funded and an object of established confidence, it answers most of the purposes of money. Transfers of stock of public debt are there equivalent to payments in specie; or in other words, stock, in the principal transactions of business, passes current as specie. The same thing would in all probability happen here [if the federal government issued debt], under the like circumstances.

The benefits of this are various and obvious.

First. Trade is extended by it; because there is a larger capital to carry it on, and the merchant can at the same time afford to trade for smaller profits as his stock, which, when unemployed, brings him in an interest from the government, serves him also as money, when he has a call for it in his commercial operations.

Secondly. Agriculture and manufactures are promoted by it…

Thirdly. The interest of money will be lowered by it, for this is always in a ratio to the quantity of money and to the quickness of circulation. .This circumstance will enable both the public and individuals to borrow on easier and cheaper terms.

Hamilton goes on to discuss why the underlying debt must be of stable value for it to service
this role as quasi-money. Here his advice would seem less relevant for US inflation, but more
relevant for the situation in the European periphery, where the unstable value of government
debt itself serves as a deflationary shock:

One serious inconvenience of an unfunded debt is that it contributes to the scarcity of money. This distinction, which has been little if at all attended to, is of the greatest moment. It involves a question immediately interesting to every part of the community; which is not other than this – whether a public debt, by a provision of it on true principles, shall be rendered a substitute for money; or whether, by being left as it is, or by being provided for in such a manner as will wound those principles and destroy confidence, it shall be suffered to continue, as it is, a pernicious drain of our cash from the channels of productive industry.

We don’t want to stretch the context of Hamilton’s statements too far to compare them to the present, but he hints at an obvious caveat to our analysis of shadow money. The expansion of the public balance sheet in order to boost prices (or counter a deflationary shock) can be a powerful tool, but the soundness of the government debt must be first established.

In the United States, given current very low interest rates, the market has not challenged the soundness of government debt, and therefore the policy has been successful.

However, in the European periphery soundness is a pressing issue. Higher haircuts and spreads on government debt in Ireland and Greece, for example, are a negative shock to public shadow money, and therefore have contributed to a broader deflationary shock.

This shows Hamilton’s insight at work: although government debt can serve as an increase in money, it can also be self-defeating if an expansion of debt contributes to soundness fears.

Fortunately for the peripheral countries, those with deeper public balance sheets, such as the ECB and other Euroland member states, stand willing to help. But exactly how and when?

What would Hamilton do in this situation?

Go Federal, and damn the politics.

This entry was posted by Guest writer on Wednesday, December 1st, 2010 at 17:57 and is filed under Capital markets. Edit this entry.